Taxes Tax Treatment of Bonds and How It Differs From Stocks By Ken Little Ken Little Twitter Website Ken Little has more than two decades of experience writing about personal finance, investing, the stock market, and general business topics. He has written and published 15 books specifically about investing and the stock market, many of which are part of the well-known franchise, The Complete Idiot's Guides. As a freelance writer and consultant, Ken focuses on stocks, trading basics, investment strategy, and health care. His work has been featured in The Wilmington StarNews, The Daily Times, The Balance, The Greater Wilmington Business Journal, The Herald-News, and more. learn about our editorial policies Updated on December 2, 2022 Reviewed by Eric Estevez Reviewed by Eric Estevez Eric is a duly licensed Independent Insurance Broker licensed in Life, Health, Property, and Casualty insurance. He has worked more than 13 years in both public and private accounting jobs and more than four years licensed as an insurance producer. His background in tax accounting has served as a solid base supporting his current book of business. learn about our financial review board In This Article View All In This Article Do Bonds Have Special Tax Treatment? How Are Different Types of Bonds Taxed? Taxes on Municipal Bonds vs. Stocks Frequently Asked Questions (FAQs) Photo: Jose Luis Pelaez Inc. / Getty Images Bonds can be an important part of your financial plan, but as with all investments, there's the matter of taxes. And when it comes to taxes, bonds can be a little more complicated than other investment options. Most investors buy bonds for two basic reasons. First, as debt securities, they are often safer than stocks if you need to protect the principal in the event of bankruptcy or default. Second, they provide a consistent and predictable stream of interest income. As a result, bonds can provide some stability for your portfolio to counter the volatility of stocks, while still generating income. Key Takeaways Stocks and their dividends receive special tax treatment, but bonds do not.Interest from U.S. Treasury bonds is subject to federal but not state or local taxes.You avoid paying federal, state, and local tax on the interest income when you buy municipal bonds from your state or locality.You pay tax on corporate bonds. But, if they're in a retirement account you won't pay it until you take withdrawals. Do Bonds Have Special Tax Treatment? Investors don’t typically look to bonds to outperform stocks, although this happens from time to time (and many an experienced bond trader would beg to differ). However, most investors view bonds as a way to help achieve stability and income in their portfolios. Then there's the tax issue. If you own stocks, you don’t pay taxes on their growth until you sell them, and then you're only taxed at the capital gains rate. Even dividends receive special tax treatment. But that's not the case with bonds. How Are Different Types of Bonds Taxed? Typically, you will receive income from bonds twice a year. This means they can have immediate tax consequences. Here’s how the tax situation breaks down per bond type: U.S. Treasury issues notes and bills that generate a federal income tax liability. They aren't subject to state or local income taxes. Municipal bonds (sometimes known as "munis") are tax-free at the federal level. If you buy them in the state where you live, they can be free of state and local taxes as well. These are sometimes called “triple free" for that reason. Corporate bonds have no tax-free provisions. You will pay taxes on any earnings from these debt securities. However, if they're held in a retirement account like a 401(k) or IRA, you won't owe tax on their earnings until you withdraw them in retirement. Zero-coupon bonds have specific tax implications. These securities are sold at a deep discount and pay no annual interest. The full face value is paid at maturity, but there's a catch. The IRS computes the "implied" annual interest on the bond, and you're liable for that amount even though you don’t receive it until the bond matures. Yes, you read that correctly. You're taxed now on the income you haven't received yet and might not receive for years to come. Note If you buy municipal zero-coupon bonds in the state where you live, you won't have to pay tax on this "phantom" interest. Taxes on Municipal Bonds vs. Stocks There's a quick way to look at how a municipal bond compares with a stock on an after-tax basis. You can compute the taxable equivalent of a municipal bond’s return using this formula: Figure your marginal tax rate, which is what you'll pay on the next dollar of income you earn. Subtract it from 1. Then divide a muni yield by the result to get the taxable equivalent. For example, if you're going to be in the 24% tax bracket, and you're considering a muni with a yield of 2.8%, the calculation would look like this: 0.028 / (1 – 0.24) = 3.68% This muni would give you the same effective return as taxable security that pays about 3.68%. If you figure in state and local taxes, it could push your taxable equivalent return even higher. This calculation lets you know whether a municipal bond is a smart investment compared to a given stock. In the long term, stocks outperform bonds, but that doesn't mean your portfolio should contain only stocks. Bonds provide a level of diversification that can cushion your assets, and your future income, during changes in the market. If you're looking for relatively secure income at a reasonable return, municipal bonds are worth a look for their tax benefits. Depending on your goals, you may find a place for them in your portfolio as part of a diversification strategy. Frequently Asked Questions (FAQs) How much tax do you pay on savings bonds? Interest on savings bonds is subject to federal income tax at your regular income tax rate. It may also be subject to gift or estate taxes. However, if you use the income for qualified educational expenses, you might not have to pay tax on it. How do I report bonds on my tax return? If you have interest from savings bonds, you should receive Form 1099-INT, which states how much interest income you had for the year. You will report this in the income section of your tax return. Was this page helpful? Thanks for your feedback! Tell us why! Other Submit Sources The Balance uses only high-quality sources, including peer-reviewed studies, to support the facts within our articles. Read our editorial process to learn more about how we fact-check and keep our content accurate, reliable, and trustworthy. Investor.gov. "Risk and Return." IRS. "Topic No. 403 Interest Received." Fidelity. "Tax Implications of Bonds and Bond Funds." Investor.gov. "Zero Coupon Bond." Treasury Direct. "Education Planning."